On the Welfare Properties of Fractional Reserve Banking

Daniel Sanches

Economic Advisor and Economist

April 2015

WP 15-20 — Monetary economists have long recognized a tension between the benefits of fractional reserve banking, such as the ability to undertake more profitable (long-term) investment opportunities, and the difficulties associated with it, such as the risk of insolvency for each bank and the associated losses to bank liability holders.

Supersedes Working Paper 13-32/R — On the Welfare Properties of Fractional Reserve Banking.

I show that a specific banking arrangement (a joint-liability scheme) provides an effective mechanism for ensuring the ex-post transfer of reserves from liquid banks to illiquid banks, so it is possible to select a socially efficient reserve ratio in the banking system that preserves the safety of bank liabilities as a store of value and maximizes the rate of return paid to bank liability holders.

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